Taxonomy matters, part 2: Keeping ESG “focused” - The next era in ESG investing

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ESG-Focused Funds:

In our continuation of reviewing fund taxonomy, we now move on to the ESG-Focused disclosure requirements. The SEC is proposing to require an ESG-Focused Fund, which would include ESG Impact Funds, to provide specific information on how the fund focuses on ESG factors in its investment process. The SEC classifies an “ESG-Focused Fund” as a fund that focuses on one or more ESG factors by using them as a consideration in:

  1. Selecting investments for the fund
  2. The fund's engagement strategy with the companies in which it invests, including a policy of voting and engaging with companies to encourage ESG practices

Examples of these funds would be a fund that tracks an ESG-focused index or utilizes a screening method to include or exclude investments based on ESG factors across investment industries.

What is interesting in this ruling is though the SEC did not explicitly state what the definition of ESG should be, they do state that for any fund that markets itself as ESG, it must provide information to investors to support its claims. Funds that are subject to this ruling are:

i. Any fund that has a name including terms indicating that the fund’s investment decisions incorporate one or more ESG factors

ii. Any fund whose advertisements or sales literature indicates that the fund’s investment decisions incorporate one or more ESG factors by using them as a significant or main consideration in selecting investments.

Again, as the SEC states, “we believe this aspect of the proposed definition can help deter funds from making exaggerated claims” for example, “ESG,” “green,”  “sustainable,” or “socially conscious.”

One might wonder why the SEC proclaims that a fund requires a definition without a full definition of what it’s aligned with? There is a great process here that a fund needs to state what it’s believing “green” or “ESG” or “sustainable” is to them, but there is a lasting concern that what is considered “green” to one manager could be very different to other managers “green” fund. A question here is, will the SEC be a watchdog of what green should mean, or is there going to be a lingering issue of continued variance of definitions without a unified, agreed-upon definition for ESG.

Impact Funds:

The SEC proposes to also define an Impact Fund as another layer of an ESG-Focused Fund that is set to achieve a specific ESG impact or impacts. Consider this as a fund that invests with a specific goal in mind, for example, creating affordable housing, or providing clean water for communities. These funds would have additional disclosure needs along with the disclosure requirements for ESG-Focused funds. For these funds, they would be required to include how the fund measure progress towards their directed impact, how long they measure the process, and the relationship between impact and the fund's overall financial returns.

The SEC believes that these additional disclosures aid in providing a clear picture of the impact the fund is seeking along with a better understanding for investors to evaluate impact in relation to returns. In an ideal world, this ruling should aid in showcasing to investors the real impact their investment has made. Granted, some tools exist to help showcase this already, that help showcase the impact their to advisors on their client’s investment impact. For investment companies, this will be a costly and complex endeavor for them to add to their process, but something that is worth the added cost to make ESG investing more transparent.

ESG Strategy Overview table:

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This new table will be added to fund prospectuses for open and closed-end ESG-Focused Funds. The stated goal of this table is to provide investors with a clear, comparable, and succinct summary of the most important features of a fund’s implementation of ESG factors.                              

This table does not replace the depth and breadth needed of the entire ESG story for each fund, but, it is a powerful way to distill the most important portions for investors to capture a brief snapshot of the fund's process and coverage. This table alone is a helpful tool, but it does not show the entire story of the fund. One shouldn't rely on this table as there is much more to the story of a funds ESG evaluation and process that is behind each box checked, and each overview section. Relying on the table alone could still raise a few transparency issues that investors might not consider if they use this table at face value, but it does allow for a form of standardization that was lacking before this proposal.

We believe that this included table is a powerful tool for advisors and investors to be able to create a more equal comparison point between funds that does not exist currently. This table is a tremendous tool that creates some standardization across different products. Though without a standardized definition of ESG, there is going to be variance in ESG factors from fund to fund. Overall these tables will be incredibly helpful in understanding trends across products and allow for a snapshot of how a fund operates in a clear and meaningful way. These tables also benefit companies focused on fund analysis to have a unified view of investment products to give better insights to their end-users and clients.

XBRL Data tagging:

These proposed regulations also will be submitted with XBRL data tagging requirements. Though this is currently standard for most funds, this data tagging method is essential for making these new disclosures easily accessible for full analysis by investors, advisors, and companies like YourStake, to be able to cleanly and efficiently intake these new disclosures.

As mentioned before, many of these proposed changes will add complexity, cost, and technology process needs for fund companies and advisors. Being sure this information is university accessible creates immense opportunities for many companies to offer better products, services, and information for end users so we can all create a more transparent ESG investing environment.

Conclusion:

Overall, these changes are again helpful for investors to have tools to gain a better understanding of the ESG investment space and have some forms of universal analysis for investment options. For advisors, these changes will again create an opportunity to align a client’s values with their investments in an easier way, especially with the ESG strategy table in place. For companies, however, these new additions will bring added costs and resource needs to put these requirements into their materials and methodologies.

In our next post, we will look at the GHG and carbon emissions disclosure needs, how they match up to the EU Sustainable Finance Disclosure Regulations (SFDR), and how to better understand Scope 1, 2, and 3 emissions.

We’re also looking for more people to join our video/audio series, if you’d like to be a part of the other component of the next era in ESG investing, reach out to: jack@yourstake.com to be a part of this series.

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